The Longtail Of Venture: Why Some Companies Will Continue To Need VC And Others Won't

There has been a lot of discussion in the venture community about
the declining cost of starting an IT company. A lot of very smart
and thoughtful VCs, entrepreneurs, and pundits have written about
this topic.

But there seem to be two contradicting viewpoints in the market.
One arguing that traditional early-stage VC will die out, another
that indicates that the early-stage VC market is improving. Here
is my attempt to rationalize the two perspectives.

Underlying Causes
Two underlying causes of this phenomenon are the declining cost
of developing technologies and acquiring customers.

• Social media (e.g., Facebook, del.ico.us) have made
it easier for customers to recommend
products, and

• Internet-based advertising channels have become
more targeted, track-able, and dependable.

Who This Affects
While most software and Internet companies benefit from the
declining infrastructure costs, not all business models equally
benefit from the changing marketing costs. Specifically, models
leveraging the Internet as their primary channel for customer
acquisition benefit more from this trend than models which
require sales personnel, as is common for companies selling to
enterprises.

Anecdotal Evidence
Before I continue, I want to point out that my conclusions about
the situation and the conclusions drawn by others appear to be
based on anecdotal evidence. So, take my perspective with a grain
of salt (the plural of anecdote is not “data”). Nonetheless, I
hope this viewpoint will provide another chapter in the on-going
dialogue on this matter.

A Potentially Superficial Contradiction
I have spoken to a handful of other VCs about this matter
recently and there seems to be some consensus that the level of
IT backable ventures that require substantial capital has
persisted. Put another way, VCs are still seeing a lot of
companies seeking full Series A, B, and C rounds. These companies
need to purchase considerable advertising inventory, employ
sophisticated staff to perform critical functions and build a
strong business development team in order to secure partnerships
with other companies. Those expenses accumulate, creating a need
for multi-million dollar investments.

Furthermore, it seems likely that the need for capital is here to
stay. Marketing costs are likely to increase as ad dollars
continue to migrate to the web. Wages also continue to rise and
we have yet to replace business development executives with
software. So long as these cost centers exist there will be a
need for venture capital.

On the surface, this conclusion seems to contradict the vision of
pundits who expect the need for traditional levels of capital
infusion to disappear over time.

While the evidence that I have heard for both sides of this trend
to date has been anecdotal, both arguments seem reasonable and
compelling. As a result, I began to wonder whether the trends
seen by both camps are correct. I asked myself, “Do these trends
have to be mutually exclusive? Is this a zero sum game?”

In an attempt to rationalize how the venture market could have
both a consistent number of startups with traditional capital
requirements and a host of new startups with less robust capital
needs, I developed a hypothesis on the matter that appears to
support both trends. I believe that companies that do not need
traditional venture capital investments make up the longtail of
venture. For simplicity, I am going to refer to these as the
“venturetail” going forward. The fact the venturetail exists does
not implicitly mean that all companies need less capital. It is
possible that venturetail companies are being started in addition
to companies that have traditional capital requirements.

More Startups?
My intuition tells me that there are two reasons why lower costs
lead to more companies being started. First, some of the Internet
companies being launched may not have been profitable endeavors
when startup costs were higher; with lower costs more business
models are economically viable. Second, the risk associated with
these ventures has declined, enabling entrepreneurs who don't
want to 'stake it all' the opportunity to pursue a startup in
their free time or without betting the house. One friend
recently said to me "if you're not starting companies in your
free time you're nuts."

The venturetail represents, in my hypothesis, a new class of
companies that is comprised of both:

• Companies that would not have been pursued when the costs were
higher and the corresponding
risk to the founders greater, and

• Companies that were not economically viable in past (costs were
too high to generate a profit).

If this intuition is correct it supports the idea that
venturetail companies have not displaced the traditional
companies, rather, the venturetail companies being launched are
incremental to traditional startups.

In sum, it seems that the presence of companies that require less
capital doesn’t seem to negate the need for traditional venture
capital checks. Rather, a new class of startups has emerged that
will be served by a different venture model. And...that's
happening. While many of the startups that might have
historically fallen off the radar due to lower capital needs and
potential are attracting the attention of VC dollars from
traditional early-stage funds and the new band of
super-angel/micro-VCs.

Starting Venture Scale Companies With Less?
Furthermore, the lower startup costs are enabling companies to
prove early milestones with less capital blurring the lines
between companies that only need a small amount of money to reach
profitability and companies that will enter the traditional
venture model down the road - both are being served by the rising
class of seed investors. I don't think, however, that this is
happening to the exclusion of more traditional Series A rounds
(and beyond).

Conclusion It's unclear exactly how this
market will evolve going forward, but one thing is certain: lower
startup costs will inevitably increase the rate of innovation…a
good thing for all of us.

Mark Peter Davis isa New York City VC and member of
the DFJ
Gotham Ventures team. This
post originally appeared on his blog and it is
republished here with permission.